by FPA member David Zuckerman, CFP®, CIMA®
Traditional economics holds that consumers make choices that will maximize their utilitarian benefits, and that investors make investment decisions that maximize returns. The underlying premise is that people are rational, unbiased, and unemotional in decision making. The reality, however, is that many individuals make irrational consumer choices and investment decisions. Behavioral economics combines the fields of psychology and economics to study the underlying causes of this irrational behavior.
Affinity bias is an emotional bias that causes irrational decisions driven by how people perceive a product to be a reflection of their values. This bias is unique in that it manifests itself in both consumer decisions and investment decisions.
A car is one of the more expensive consumer goods that you purchase in any given year; and, as a result, your purchase decision can impact your personal finances in a big way. Unfortunately, for many people, buying a car is a largely emotional decision. Consider the consumer that drives only a few thousand miles each year, but decides to purchase a car with hybrid technology. While the added cost of buying a car with hybrid technology is not justified by the utilitarian benefits of improved fuel economy, this consumer is focusing on the perceived expressive benefits of the car. Like the buyer of an expensive Italian sports car that is trying to impress people, buying a car that communicates environmental consciousness can also be a form of self expression.
The automotive industry also provides other examples of affinity bias with respect to irrational investment decisions. For example, susceptible investors may purchase an automaker’s stock in order to express their support for the industry of a specific country or a particular automaker without conducting any significant due diligence.
Home Country Bias
Home country bias is another form of affinity bias. The tendency of investors to overweight domestic equities and underweight foreign equities has been well documented by the academic community. Studies have shown that U.S. investors hold, on average, only 14 percent of their equity exposure in non-U.S.-based companies. A portfolio that accurately reflects market capitalization around the world, however, would require over three times as much exposure to non-U.S.-based companies. Since there is overwhelming evidence that international diversification improves long term returns, affinity bias will reduce investment returns to the degree that some investors forgo these benefits in favor of the benefits of perceived patriotism.
Investment Products as Status Symbols
Affinity bias can even manifest itself in investors’ preference for certain types of investment products that are considered popular and sophisticated. This can happen when investors buy something that they do not understand in order to acquire the prestige associated with a certain type of product. Perhaps the most glaring example of affinity bias was Bernie Madoff’s Ponzi scheme, which attracted investors by bestowing an air of exclusivity and prominence that being a Madoff investor was thought to convey. Unfortunately, Madoff investors wound up paying dearly for their mistakes; and investors that decide to invest in a hedge fund or other product type based solely on the status of other investors could wind up with similar results.
Focus on Inexpensive Self Expression
Investment returns can suffer when decisions are motivated by emotional forces that ignore fundamental investment analysis. Affinity bias can compel people to make irrational decisions about consumer products and investments that favor perceived expressive benefits over utilitarian benefits. Does that make it wrong for you to use consumer products as a means of self expression? Not necessarily; but, in order to minimize the detrimental effect that affinity bias can have on your personal finances, try to focus on inexpensive products when seeking expressive benefits. For many people the unnecessary cost of buying prestige products – especially expensive cars - to cultivate a perceived image of exclusivity represents one of the biggest financial pitfalls in consumer decision making. Remember, Sam Walton drove a pick-up truck and Warren Buffet still lives in the home he bought in 1957 for $31,500.
If you need help assessing your susceptibility to home country bias or conducting due diligence on a particular product type that you find appealing, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association with the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
2Michael Pompian, Behavioral Finance and Investor Types (John Wiley & Sons, Inc., 2012), 43-44